Why Scandinavian Tobacco Group A/S’s (CPH:STG) Return On Capital Employed Might Be A Concern

Today we are going to look at Scandinavian Tobacco Group A/S (CPH:STG) to see whether it might be an attractive investment prospect. Specifically, we're going to calculate its Return On Capital Employed (ROCE), in the hopes of getting some insight into the business.

First, we'll go over how we calculate ROCE. Then we'll compare its ROCE to similar companies. Then we'll determine how its current liabilities are affecting its ROCE.

Return On Capital Employed (ROCE): What is it?

ROCE measures the amount of pre-tax profits a company can generate from the capital employed in its business. All else being equal, a better business will have a higher ROCE. In brief, it is a useful tool, but it is not without drawbacks. Renowned investment researcher Michael Mauboussin has suggested that a high ROCE can indicate that 'one dollar invested in the company generates value of more than one dollar'.

How Do You Calculate Return On Capital Employed?

The formula for calculating the return on capital employed is:

Return on Capital Employed = Earnings Before Interest and Tax (EBIT) ÷ (Total Assets - Current Liabilities)

Or for Scandinavian Tobacco Group:

0.076 = ø952m ÷ (ø13b - ø1.1b) (Based on the trailing twelve months to September 2018.)

Therefore, Scandinavian Tobacco Group has an ROCE of 7.6%.

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Is Scandinavian Tobacco Group's ROCE Good?

One way to assess ROCE is to compare similar companies. We can see Scandinavian Tobacco Group's ROCE is meaningfully below the Tobacco industry average of 14%. This could be seen as a negative, as it suggests some competitors may be employing their capital more efficiently. Aside from the industry comparison, Scandinavian Tobacco Group's ROCE is mediocre in absolute terms, considering the risk of investing in stocks versus the safety of a bank account. It is possible that there are more rewarding investments out there.

When considering this metric, keep in mind that it is backwards looking, and not necessarily predictive. ROCE can be deceptive for cyclical businesses, as returns can look incredible in boom times, and terribly low in downturns. ROCE is, after all, simply a snap shot of a single year. Future performance is what matters, and you can see analyst predictions in our freereport on analyst forecasts for the company.

Do Scandinavian Tobacco Group's Current Liabilities Skew Its ROCE?

Short term (or current) liabilities, are things like supplier invoices, overdrafts, or tax bills that need to be paid within 12 months. The ROCE equation subtracts current liabilities from capital employed, so a company with a lot of current liabilities appears to have less capital employed, and a higher ROCE than otherwise. To counteract this, we check if a company has high current liabilities, relative to its total assets.

Scandinavian Tobacco Group has total assets of ø13b and current liabilities of ø1.1b. Therefore its current liabilities are equivalent to approximately 8.2% of its total assets. With low levels of current liabilities, at least Scandinavian Tobacco Group's mediocre ROCE is not unduly boosted.

The Bottom Line On Scandinavian Tobacco Group's ROCE

Scandinavian Tobacco Group looks like an ok business, but on this analysis it is not at the top of our buy list. But note: Scandinavian Tobacco Group may not be the best stock to buy. So take a peek at this freelist of interesting companies with strong recent earnings growth (and a P/E ratio below 20).

I will like Scandinavian Tobacco Group better if I see some big insider buys. While we wait, check out this freelist of growing companies with considerable, recent, insider buying.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.